Analysis: What next for European ITs?

Our analysis shows that European investment trusts have in recent years delivered strong returns to investors from their current discount, but risks abound in 2017…

Background

In September last year we examined European investment trusts which had, in the wake of the surprise result of Britain’s referendum on leaving the EU, seen their discounts widen dramatically amid soaring panic among investors.

The average discount in the IT Europe sector almost doubled in the month after the referendum, by which point European equity funds had seen record outflows – and our interest was piqued by the idea that further political shocks might result in similar slides for European trust shares.

This was interesting to us because our research showed that many of the trusts in this sector were, and still are, ‘European funds’ only in the sense that they invest in companies which are domiciled on the continent of Europe.

So, while the sector was seeing its share prices battered by fears about the health of the European Union in the wake of Brexit, many of the funds it contained were focused on the world’s largest multinationals, drawing revenue streams from all over the world, and often not even domiciled in Eurozone countries.

Roche Holdings, for example, is the most popular stock in the sector – held by five of the twelve trusts the sector contains and accounting for 2.28% of all the assets invested in European investment trusts. The company, based in Switzerland (not part of the EU), has manufacturing sites in 26 countries and a major footprint in the world’s largest market for healthcare, the US. It employs more than 80,000 people, recorded profits of $9bn (£6.8bn) in 2014, and has increased its dividend every year for the last 27 years.

Further political shocks, we postulated, could see discounts plunge again – making it possible to gain exposure to funds with exposure to global companies like this at a discount to their net asset value.

Since then the market has been remarkably resilient. We thought Renzi’s resignation in December, for example, would have sparked significant outflows and – like many others – thought a Trump victory would result in a flight to safety affecting equities across the board.

Neither of those things really happened, quite the opposite in the case of Trump, but the possibility of that Italy may still leave the EU – considered ‘medium risk probability’ by the team at Schroders – means there is time yet for that prediction to come true.

In the meantime, our analysis shows that – on the 22 occasions since May 2008 when the discount has been at its current level (9.4%) – European investment trusts have, on average, returned 17.4% in the subsequent twelve months.

These statistics make for interesting reading, but risks abound…

Discount volatility

Since share prices plunged in the immediate aftermath of the referendum there has been a gradual recovery and the average discount at the end of January stood at 9.4%, not far below the level at which it stood before the vote (8.7%).

Unloved Europe

Source: Morningstar/Kepler Partners

Looking at the longer term, discounts among trusts in the region were much tighter between late 2012 and early 2016, but this – in our view – was an exceptional period underpinned by quantitative easing, the start of which coincides exactly with Mario Draghi’s ‘anything it takes’ speech.

Long-term discounts

Source: Morningstar/Kepler Partners

If we look further back, discounts have generally remained wider than 8%, but against that limit they have traded in a volatile range.

Our analysis shows that – on the 22 occasions since May 2008 when the discount has been at its current level (9.4%) – European investment trusts have returned 17.4% in the twelve months which followed that point. The same statistics also show us that, more often than not, European equities (as represented by the MSCI Europe ex UK index) have outperformed equities globally (as represented by the MSCI AC World Index).Time to pile in?

At this point you could be forgiven for thinking that the message here is that you should pile into European equities. After all, the odds are that you’ll be up in twelve months time – isn’t that what we’re saying?

Well, no. It isn’t.

Exposure to the global companies which these European investment trusts have in their portfolios as part of a balanced and diversified investment strategy is no bad thing, and buying into these trusts when they are on a discount allows you to gain that exposure at a time when the trust’s share price is below the value of the assets that these shares represent.

However, discounts can widen, even if they have narrowed from this level in the past – and even if discounts stay the same, NAV performance may be negative – leaving you worse of in twelve months time. Indeed, on four occasions since our analysis began in May 2008, European investment trusts have lost more than 20% of their value.

Even ignoring Brexit, Europe faces unique challenges, and many of them are likely to come to a head in 2017. In France the forthcoming general election will very likely see Marine Le Pen, leader of the French National Front, reach the second round and – while the consensus is that she will not make it to the Elysee Palace – to ignore the possibility that she might would be foolish, as her odds of 2/1 reflect.

Considered more likely, though we hope not inevitable, is that Italy might join us in abandoning the project altogether, dumping the euro which is crippling its economy and in the process defaulting on its enormous debts. If that happens, according to Schroders economist Keith Wade, the changes of the Union’s survival are slim – and the outlook for European investment trusts in that environment is clearly poor.

Even assuming neither of those risks crystallises, there is already a major risk in play. Rising protectionism is not good for international trade, which undermines the type of multinational companies these trusts are exposed to, and big pharma in particular has come under heavy fire about ‘gouging’ from politicians on both sides of the Atlantic.

Our analysis of holdings in the sector shows that pharmaceutical giants are among the largest holdings in a number of trusts across the sector.

Top ten holdings in the IT Europe sector

Source: Morningstar/Kepler Partners

It is interesting, with these anxieties in mind, to look at what the professionals are doing. Our analysis shows that exposure to Europe has been falling steadily among funds in the IA Global sector – the AIC Global sector’s much larger open ended equivalent.

Exposure to the region via investment trusts, as represented by the weightings in the AIC Global sector, has fallen slightly – but reflects more closely the diminished weighting that the region makes up in the MSCI World equity index, suggesting that tit that more to do with valuation versus other elements of the index than an active selling-down of assets.

What are the professionals doing?

Source: Morningstar/Kepler Partners

Given the level of risk which Europe is currently exposed to, and the various potential ‘inflection points’ that 2017 contains, global funds may actually be an interesting alternative for those who want exposure to the region.

As the chart above shows the average global investment trust has around 15% of its assets in Europe and at least until the near term outlook becomes less ‘flou’, that may just be enough.

Investment Trust Intelligence is published by Kepler Partners LLP. This research is aimed only at providing information to private investors. No information or opinions contained here constitute a solicitation or inducement by Kepler Partners LLP to buy, sell or subscribe for any securities mentioned herein or to provide any investment advice or service.

Neither Kepler Partners LLP nor Investment Trust Intelligence give advice based on personal circumstances so you are responsible for deciding whether an investment is suitable for you. In doing so, please remember that past performance is not necessarily a guide to future performance, the performance of funds is not guaranteed and the value of your investments can go down as well as up, so you may get back less than you invest.

When investments have particular tax features, these will depend on your personal circumstances and tax rules may change in the future. Before investing into a fund, please read the relevant Key Investor Information Document (KIID). You should regularly review your investment objectives and choices and if you are unsure whether an investment is suitable for you, you should contact an authorised financial adviser.

This research is made available without responsibility on the part of Kepler Partners LLP, who neither assumes nor accepts any responsibility or liability (including for negligence) in relation thereto.

No action should be taken or omitted to be taken in reliance upon information on this research. Opinions expressed are subject to change at any time. The material is based upon information which is considered reliable, but no representation is made as to accuracy, completeness or timeliness, and should not be relied upon.

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